Eli Dourado

Etsy and the business cycle

Reihan Salam offers some very good thoughts on self-employment via Etsy and Kickstarter as a possible driver of economic recovery, in which he kindly quotes yours truly on technologies of control and resistance. What follows are just a few additional ideas on self-employment prompted by his post.

In response to Reihan, Justin Wolfers tweets that, in fact, self-employment is falling, citing BLS data. I’m not totally persuaded that the metric Wolfers points to, “Self-employed workers, unincorporated,” actually captures all the movement we are observing. To the extent that more people are interested in self-employment, thicker markets in incorporation services develop, so it’s possible that unincorporated self-employment could fall even as total self-employment increased. More importantly, a lot of people have several income streams, only one of which is a full- or  part-time job. Unless I am mistaken, these people show up in the household survey as employed either full-time or part-time, even though their Etsy/Kickstarter/App Store/Kindle Single incomes are economically or otherwise important.

I was in that category last year. I had a part-time job, but I earned more money through the Mac App Store and various freelance economist gigs than I did from my job. I have a good friend who works part time so that she can pursue her passion for felting through Etsy (and increasingly, other avenues). I have no idea how substantial her Etsy income is, but I know that Etsy is an important part of her life.

Putting aside whether self-employment is rising, I am convinced that self-employment is desirable, other things equal, from a business cycle perspective. This is true whether you are a Keynesian or a ZMP theorist. A popular Keynesian story is that when demand falls, workers refuse to accept nominal wage cuts without a corresponding decline in morale, making them less productive. Consequently, firms prefer to fire a fraction of the workforce and then announce “no more layoffs” rather than cut wages for everyone. Promises from laid-off workers to work at half their former salary with no decline in morale are not credible. Self-employment maybe doesn’t solve the problem of low morale during a recession, but it at least obviates the need to make promises about future work at low salaries. When demand falls, self-employed workers accept lower wages, at least until they find other employment, because what choice do they have? And there is no one they need to convince to keep them on staff.

There is something to the morale story, although I have a hard time believing it can explain a protracted recession. I’ve been pushing a version of ZMP theory that considers the agency costs associated with overseeing employees as roughly a fixed cost (I consider this version a complement to, not a substitute for, other versions of ZMP that are based more on coordination and recalculation). Although we teach in freshman econ that the wage equals the marginal product of workers, workers also have to cover the overhead associated with hiring them, which is often substantial. A major part of the cost of employing workers is the cost of supervising them, and this cost is fixed with respect to demand. If we suppose that a worker can produce $30/hour and costs $15/hour to employ, the worker will take home $15/hour in wages, his net marginal product. If demand falls so that the worker’s output is valued at $20/hour, and the cost of employing him remains $15/hour, his net marginal product falls to $5/hour, which is below the minimum wage. The employee is therefore unemployable, even if his wage demands are totally flexible, and he will be fired.

In this example, a 33% decline in the value of output resulted in a 67% decrease in net marginal product and a 100% decline in employment. Fixed management costs, therefore, tend to amplify the effect on workers' employment prospects of shocks to demand (or supply). Because there are no agency costs associated with self-employment, demand and supply shocks are not amplified among the self-employed. Employment is fragile; self-employment is robust. We should expect that a self-employed economy would not be as susceptible to long recessions as an employed one.

It is worth exploiting an analogy with another fragile market, the market for bonds (and for other financial claims with priority). It is well understood among economists that debt instruments are more fragile than equity instruments. The value of a bond is relatively insensitive to changes in the underlying income stream when profits are high, but becomes extremely volatile when the underlying income stream approaches the margin at which repayment comes into question. The volatility is compressed into a narrow range of profit space. In contrast, if an income stream is divided only among a single tier of equity, the value of the equity instrument will vary smoothly with the income stream.

The net marginal product of an employee with substantial management costs is like the value of a bond. It varies relatively slowly when business conditions are good and becomes extremely volatile at the low end of the business conditions spectrum. The volatility is concentrated, if not fully compressed, into a relatively small range of outcome space. And concentrated volatility means fragility. Many economists recognize that it is desirable for an economy to limit its use of debt finance in favor of equity finance. Financial systems that are heavily reliant upon debt are prone to crisis when times get bad. Similarly, when employee management costs are high, it is desirable for an economy to limit its use of employment in favor of self-employment.

In paragraph 4, I added an important caveat: “other things equal.” People generally work for firms because firms are productive intermediaries. But to the extent that Etsy, Kickstarter, and other platforms can disintermediate the labor economy, we should be very grateful. Not only are these platforms beneficial technologies of resistance as Reihan emphasizes, they might be generators of macroeconomic robustness.